Sunday, May 31, 2015
IEA's shadow MPC votes 6-3 to hold rates
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following the pattern of the last few meetings, albeit with a smaller majority,
the SMPC has voted to hold Bank Rate in June. The election result, and
the consequent removal of some of the political uncertainty, had little
impact on the voting.

The majority continued to argue that rates should remain on hold due to
negative inflation and worries about growth later in the year.

Those arguing for higher rates remain worried about financial market
distortions caused by leaving rates ‘too low for too long’, and wanted to
at least start to normalise rates.

The SMPC is a group of economists who have gathered quarterly at the
IEA since July 1997. That it was the first such group in Britain, and that it
gathers regularly to debate the issues involved, distinguishes the SMPC
from the similar exercises carried out elsewhere. To ensure that nine votes
are cast each month, it carries a pool of ‘spare’ members. This can lead
to changes in the aggregate vote, depending on who contributed to a
particular poll. As a result, the nine independent and named analyses
should be regarded as more significant than the exact overall vote. The
next two SMPC polls will be released on the Sundays of 5th July and 2nd
August 2015, respectively

Votes

Vote by Jamie Dannhauser
(Ruffer)
Vote: Hold Bank Rate & QE
Bias: No bias
One year ahead: Bank Rate at 1%; no change in QE

Official data suggest the UK economy hit a soft patch in the first
quarter. Output expanded by only 0.3%, despite the tailwind that lower
oil prices are providing to UK real incomes. Consumer spending growth
came in at 0.5%, although more timely data on retail spending suggest
this apparent slowdown is largely transitory – the volume of sales in
April was markedly higher than the first quarter average, implying a
potentially much stronger Q2 outturn for consumer demand.

The more important point is that business surveys suggest the economy
is much more robust than the ONS’ official data. There appears to be
an especially large discrepancy in the construction sector, where ONS
figures point to declining output. But the gap between survey evidence
and recorded output is fairly widespread.

As relevantly, forward-looking indicators suggest the economy will
continue to grow at an above-trend rate in coming quarters. There are
especially encouraging signs that house-building is gathering pace;
and corporate investment intentions remain elevated. Two additional
considerations are pertinent: first, the tailwind from oil, which theory
suggests should be at its most supportive in Q2 and beyond; and
second, a further easing of credit constraints, which should bolster
monetary growth and lower the precautionary demand for cash.
As has been true for some time, an external ‘shock’ is the greatest
threat to the UK growth outlook. The debacle in Greece still poses
a meaningful threat to the Euro Area and by implication UK export
demand. China too is a worry, given the severity of the downturn in
the construction sector, the key fault line in the Chinese financial
edifice. However, there are also upside risks that should be taken into
account, including a positive Euro Area growth surprise as well as a
strengthening of the Japanese economy.

The case for not beginning the rate normalisation process centres on
the weakness of inflation, especially measures of underlying inflation.
The negative print on headline inflation should not concern us, since it
is largely a product of sharply lower oil prices. However, we have seen
a marked fall in ‘core’ CPI inflation in recent months, as well as a rapid
decline in retailers’ margins. Both would be consistent with a greater
degree of slack than is widely perceived. Some have suggested this
reflects the upward move in sterling and the counterpart change in
import prices. While surely playing a role, it is notable that the rate
of inflation for consumer items with a low import-component has also
fallen markedly this year.

Monetary policy has to be forward-looking though, so at issue is
prospective inflation. The economy has had two years of above-trend
growth. That seems likely to continue for the rest of 2015 and beyond.
While there remains huge uncertainty about the current degree of slack,
and the extent to which potential supply is responding to faster demand
growth, there is surely a good deal less spare capacity than seemed to
be the case two years ago. Indeed, forward-looking indicators of wage
growth suggest improving trends ahead.

One should also note decent monetary growth, as well as evidence of
a further easing of credit constraints in both the mortgage market and
SME lending market. Depressed underlying inflation provides a reason
to hold off a rate move this month. Subject to a clear turnaround in
domestic pricing pressures, and a resolution of the Greek debacle,
however, the case for a hike later this year could become compelling.

Vote by Anthony J Evans
(ESCP Europe Business School)
Vote: Hold Bank Rate
Bias: Raise once inflation returns to 1%-3%

According to the ONS house price inflation rose from 7.4% to 9.6%, Halifax
report that house prices are growing at 8.5% and Nationwide at 5.2%. The
message across all of these measures is the same: house price remains
strong and even ticking up slightly. The concern is that this suggests home
owners are capitalising on low interest rates to gamble on capital gains.
March 2015 saw Average Weekly Earnings grow at 4.3% in the private
sector (compared to the previous month) compared to an average of just
1.4% from September 2013 through February 2015.

Divisia money is growing at a sustained, strong rate whilst M4ex growth for
March 2015 was back up above 4%. M3 growth continues to be negative,
but the rate of deflation jumped from -3% in February to only -0.5% in March.
If the Bank of England were blindly following their inflation targeting remit,
then there is a stronger case for looser monetary policy than tighter. Recent
sluggishness in CPI has now turned into outright deflation; however it is
of a mild and benign sort. Driven by transport services and food there
is little to suggest that it is a symptom of insufficient aggregate demand,
although the second estimate of the National Accounts will be a crucial way
to assess this (especially if nominal GDP falls below 4%).

Overall my concern is that the Bank of England is contributing to
misallocations of capital due to low interest rates adopted during a crisis.
We have clearly emerged from that crisis period and any opportunity
should be taken to normalise interest rates. Temporarily low inflation must
put those plans on hold, but not indefinitely.

Vote by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate
Bias: Neutral

Going into the election on 7 May, the British economy was in robust shape.
Growth was strong and inflation near post-war record lows, enabling real
wages to start showing meaningful growth. This background means that with
the Conservative party continuing to hold the reins of power, there should be
little change in the immediate outlook, although longer term uncertainties
about membership of the EU and the future of the union with Scotland may
persist. In the short term financial markets have welcomed the return of Mr
Cameron with increases in the stock market and the value of sterling, and a
surge in the number of deals for London property.

Although the ONS reported that the GDP had increased by only 0.3% in the
first quarter of 2015 (or about 1.2% annualised, and 2.4% year-on-year), this
probably overstated the slowdown in the economy. Services increased by a
moderate 0.5% in the quarter, while construction, production and agriculture
all declined. However, economic surveys both prior to the initial GDP estimate
and subsequently, as well as official data series have reported much stronger
growth than was reported by the GDP figure.

For example, the PMI survey released on 6 May showed service sector activity
rising to 59.5 in April from 58.9 in February, well above its long-term average
of 55. Moreover, the composite PMI (comprising services, manufacturing and
construction) is at a level that suggests that the underlying GDP growth rate
is nearer 3% than 2%.

Another example is the strength of labour market data as conveyed by the
ONS report on 13 May. Job growth continued to increase, rising by 1.8% over
the year to 2015 Q1, and up 0.7% quarter-on-quarter. Jobs are growing much
more rapidly than the size of the workforce (+0.5% year-on-year), with most
of the new jobs now concentrated in full-time work (+2.9%). With job growth
outpacing workforce growth, the unemployment rate continues to fall steadily,
declining to 5.5% in Q1 from 5.7% in Q4 2014 and 6.8% a year earlier. Also,
although the number of job vacancies fell slightly in the first quarter, the figures
are at their highest level for any month except two since data started to be
collected in 2001.

Reflecting the gradual tightening of the labour market, both regular pay and
total pay have been steadily accelerating over the past year. Average earnings
(ex-bonuses) increased by 2.7% year-on-year in March from 2.4% in February
and 1.6% in January. This is the strongest growth since the onset of the crisis
in 2008-09. When combined with the fall in the CPI inflation rate to -0.1% in
April, this means that real wages are starting to show meaningful increases.
Thanks to the buoyancy in the economy, the public finances are also starting
to look better. In the financial year to March 2015 the PSNB (excluding public
sector banks) was £87.7 billion (4.8% of GDP), down from the previous year,
and in April the PSNB was £6.8 billion compared with £9.3 billion a year earlier.
Although receipts from taxation and other sources have been consistently
disappointing (exacerbated by regular increases in personal allowances at
the lower end of the income scale and international companies diverting
income abroad), government cash outlays excluding interest have accelerated
to 6% over the year since March 2014 (thanks in part to the ring-fencing of
expenditures on health and overseas aid). In the mini-Budget announced for
8 July we should expect further cuts in expenditure by those government
departments not protected by the ring-fence, additional anti-avoidance
measures and the closing of tax loopholes to ensure that revenues run closer
to target.

On the monetary policy front there is no reason to expect any change in the
mandate for the Bank of England to maintain the 2% inflation target. With CPI
inflation in April well below target at -0.1% year-on-year (headline) and 0.8%
(core) it is likely that the Monetary Policy Committee (MPC) will continue to
keep interest rates unchanged at 0.5% in the near term. In the May Inflation
Report the Bank’s forecasts for real GDP growth were lowered slightly to 2.6%
for both 2015 and 2016 (down from 2.9%), due mainly to lower investment
spending but also to slower consumer spending growth. Again this reinforces
the case for no change in rates.

M4x growth remains moderate at 4.5% year-on-year (in March), broadly
unchanged from its growth rate of the past two and a half years, implying no
upside threat to the 2% inflation target. On the lending side M4 Lending
declined at -1.6% year-on-year in March. This is despite the two government
credit promotion schemes (“Funding for Lending” and “Help to Buy”), and
near-zero interest rates, and reflects the anxiety of the public to repair balance
sheets before embarking on renewed borrowing.

Although the amount of slack in the economy is diminishing, my view is that
low inflation will remain compatible with lower than normal unemployment
rates. This is a result of the decline in the equilibrium unemployment rate -- in
turn partly due to tighter enforcement of eligibility criteria for unemployment
benefits -- which should enable the MPC to delay any rate increases.

Also, although the MPC expects inflation to return to target after the oil price
declines of last autumn fall out of the year-on-year comparisons, it is unlikely
that the Bank will raise rates ahead of the Federal Reserve. This implies that
the first rate hike will likely be in the final quarter of 2015 at the earliest, though
it could be delayed until early in 2016. Thereafter rate hikes are likely to be
slower and more gradual than in previous cycles.

Under these conditions there is little danger of a surge in credit, a surge in
growth, or an inflationary outburst. On the contrary, given low money and
credit growth, the risks are currently tilted towards slower growth and deflation.
It would therefore be unwise to raise interest rates or otherwise tighten monetary
conditions. Rate increases at this stage would damage the prospects for
economic recovery, and should be delayed until the recovery is substantially
more vigorous in both real and nominal terms.

Vote by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate
Bias: To raise rates as inflation rises above target

No change to commentary from last vote.

Vote by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate
Bias: To raise and QE to be reversed

There was much wailing and gnashing of teeth over the uncertainties
surrounding the election result. On the one hand many feared a Labour
minority government supported by the SNP. On the other a continued
Conservative coalition of some sort scared the euro-phile mainstream press,
CBI et al. with the prospect of a referendum on the EU.
Both sets of fears were badly exaggerated.

A Labour minority government would have been unable to pass much of the
left-wing agenda Miliband had at various times threatened. It had potential
trouble at several levels. First, if he had felt he had a chance of forming a new
government later after another election he would have wished to attract votes;
left-wing policies such as rent controls would have been attacked strongly as
making it difficult for the very people it was designed to help (e.g. to find rented
accommodation).

Second, Miliband would have had to get a majority for each of these controversial
policies; and this seemed highly doubtful or would have required a big
expenditure of political capital. Yet this would have needed to be hoarded for
mere survival.

Third, Miliband was likely to face a sterling crisis fairly early, if not at once. He
would have wished to prove his orthodoxy in financial matters by pressing
ahead with his fiscal plan, and not alarming business whose tax revenues he
would have needed.

In short if Labour had governed it would not have had the sort of strength that
allowed Attlee for upend the way the UK was organised- or for that matter
that Mrs. Thatcher enjoyed, allowing her to bring in a wide-ranging set of free
market reforms. Labour would have been constantly on the edge of collapse
and desperately seeking day-to-day survival by keeping out of controversy.
While no doubt the SNP would have goaded it into left-wing policies, it would
not have been able to supply the votes to bring them about; furthermore
Labour would not have wished to be seen as sharing the SNP’s far-left agenda,
for fear of losing the floating voters who might in future have given it power.
Anyway, all that was not to be. Now turn to the vexed question of the
Conservatives and ‘Brexit’. Those wishing to stay in the EU as it now is fear
that Brexit will mean severing all ties with the EU and going into an aggressively
hostile relationship. However this is by no means what is intended; rather it
would be a renegotiation replacing our EU membership with a new bilateral
UK-EU treaty, preserving the good aspects of the existing relationship. It would
feel quite like the old membership but without the long list of sticking points
that have soured relations for so long.

It is routine to point to the threat of Brexit to inward investment. But while
indeed investment in industries that have been favoured by Brussels
protectionism will fall off, investment in industries benefiting from the fall in
costs from ending this protectionism will expand. These industries will be
ending the ‘trade diversion’ that favoured EU markets, and expanding in world
markets outside the EU. There will be major opportunities in these markets
which investors will wish to exploit.

Another factor that should calm nerves now is the UK recovery and the world
background of stable recovery with low commodity prices. I have argued
before that there will be a long upswing in the world economy, lasting another
20-25 years, as low commodity prices stimulate investment and consumption
in developed commodity-using economies.

The official GDP figures for the first quarter of 2015 have been disappointing,
at 0.3% growth. However, they are as so often at variance with other indicators,
notably the purchasing managers’ indices (PMIs); as a result they, like earlier
weak GDP estimates, will be revised upwards. There are particular discrepancies
between the construction GDP estimate, down 1.6%, and the construction
PMI which remains strong. This usually occurs with recession figures, that
over time they get revised greatly upwards. The reason for this is that in
recessions patterns of business are forced to change because of the pressures
for survival; the ONS statisticians only find out these new patterns long
afterwards and hence inadequately sample the new places where business
has shifted to. This gives the estimates a downward bias. You might well ask
why the statisticians do not aim off for this. But to do so would require putting
forward judgements that would by definition be hard to justify with concrete
data; with the GDP figures being highly politicised they simply cannot go
beyond the figures they actually have.

Hence my view remains that the UK is continuing with a reasonably robust
recovery, even if it is not as strong as in previous recessions. The question
is when rates should rise. With the US soon to raise rates itself this question
is going to become more pressing.

It may seem odd but my biggest concern is with the quantity of high-powered
money, M0. It is annoying that the Bank has ended the publication of this
series, just as it has exploded in value- presumably this is why, which
demonstrates the periodic infantilism of the Bank. However, it is easy enough
to calculate from the Bank’s balance sheet; basically M0 has multiplied about
8 times since the beginning of the crisis. All of it, except notes and coin which
has risen moderately and in line with consumer spending, is languishing in
the Bank as bank reserves. The counterpart assets bought by the Bank,
mainly government bonds, are sitting on the Bank’s balance sheet. Their
purchase drove down government bond yields and drove up equity prices in
sympathy. The low yields on these assets is fuelling the growth of lending
outside the banking system- itself overwhelmed by the new regulation. It
concerns me that we may be losing control of the next credit boom.

I urge therefore the same mixture as before: rolling back the bank regulation
(which may quietly be going on), selling off these assets steadily (maybe at
£25 billion per month), and slowly raising bank rate. Somehow the Bank needs
to get back in control of the monetary situation and show foresight of the risks
it may be running over the next two years. People will say this is not the time
to do this when inflation is low and even slightly negative. But inflation is not
really a good major target for monetary policy as we discovered during the
boom of the 2000s; it neglects the build-up of money and credit. We need to
focus on these directly or else to shift to a target like the price level of nominal
GDP that mirrors that build-up.

Vote by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate
Bias: To raise Bank Rate in two steps, perhaps starting in August

From the viewpoint of the monetary policy maker, the main gain from the 7th
May election result was that it removed potential uncertainties about the fiscal
and monetary backdrop and meant that it was back to ‘business as normal’
where rate setting was concerned. This does not imply that there are no risks
associated with what appears to be a slowly improving international background
and, longer term, the referendum on Britain’s continued membership of the
European Union. Nevertheless, the election result itself provided no reason
for changing one’s prior view about the appropriate course of Bank Rate. This
is something that would not have seemed likely a month or more ago. It is
noteworthy that the financial markets were barely perturbed by the risk of a
left-wing ‘coalition from hell’ gaining office, despite minor markdowns in equities
and gilts on election-day itself. International investors may have been sufficiently
detached from the domestic political debate to be able to make a shrewder
appraisal of the likely outcome than home-based commentators, particularly
if foreign investors were not paying attention to the BBC. Whatever the reason,
the collective wisdom of the markets appears to have outperformed both
British political pundits and the UK polling industry. The latest available (26th
May) financial prices show that the FTSE 100 index has risen by 0.9% since
the close of business on 7th May, which is almost identical to the 0.8% hike
in the US S & P composite index over the same period, while UK gilt yields
are only trivially (around 0.1 percentage points) lower they were in the days
before the election, as has also been the case in the US.

The one variable where there has been a more marked response is sterling,
where the Bank of England’s trade-weighted index dropped from 91.3 (January
2005=100) on 30th April to 89.2 on the evening of polling day before climbing
to 92.2 on 26th May, which represents a gain of 3.5% on its election night
low-point. Changes in the external value of sterling are one of the main
transmission mechanisms through which monetary policy operates in a small,
open and trade-dependent economy such as Britain’s. This means that
currency movements have important implications for the level of activity, the
domestic price level and its rate of change (i.e., inflation). The current strength
of the pound suggests that UK inflationary pressures will remain comparatively
subdued at a time when international inflation is itself running at a very low
rate. However, a potential sting in the tail, following the Conservatives’ election
victory, is the possibility that firms were holding off capital formation and
recruitment before the election, because of the perceived political risks, but
that this pent up demand will now come through in an abrupt surge. Compilation
and publication delays mean that it will be several months before it becomes
clear in the official data whether this is the case or not. However, it adds to
the risks of economic overheating, if the monetary authorities end up doing
too little, too late.

Certainly, recent indicators suggest that there are now pockets of serious
strength where the British economy is concerned, at the same time as
inflationary pressures remain subdued. One noteworthy example is the
volume of retail sales, which expanded by 1.2% in April to give a 4.7%
increase on the year, representing the longest period of sustained annual
growth since May 2008. In year-on-year terms, UK manufacturing output
has also shown consistently positive growth since August 2013, even if this
rate of increase appears to have tapered off since last autumn. In March
alone, manufacturing production rose by 0.4% on the month and 1.1% on
the year while the first quarter saw an increase of 1.3% on the first quarter
of 2014 but one of only 0.1% on the previous three-month period. Recent
labour market statistics, which are often considered to be a lagging indicator
of the economy, also suggest that home demand remains buoyant with total
employment on the Labour Force Survey (LFS) measure 564,000 higher in
the first quarter of 2015 than a year earlier and 202,000 up on the final
quarter of last year. The LFS measure of unemployment has eased from
6.8% in the first quarter of 2014 to 5.5% in the first quarter of 2015, when
it was 0.2 percentage points down on the final quarter of last year. Claimant
count unemployment also fell by a further 7,100 in April to 487,000 (2.7%),
which compares with the 712,400 (4.0%) recorded in April 2014. However,
some of the decline in claimant-count joblessness may have resulted from
the phased introduction of the ‘universal credit’ benefit, which took 4,000
off the claimant count in April 2014 but 35,600 off this April.

However, perhaps the strongest sign of rampant UK demand was the fact
that the annual rate of house price increase, as measured by the Office for
National Statistics (ONS), accelerated from 7.4% in February to 9.6% in
March, despite the threat then posed by the possibility of a high-tax Labour
government. It will be interesting to see what happens to reported house
prices in a few months’ time when the post-election period gets included in
the ONS figures. Meanwhile, the latest figures for producer prices, as well
as consumer and retail prices, suggest that inflation is certainly dormant, if
not necessarily dead. Producer output prices, which used to be considered
a leading indicator of retail prices, fell by 1.7% on an all-items basis in the
year to April and only increased by 0.1% on the year if food, beverages,
tobacco and petroleum products are excluded. Over the same period,
producer input costs fell by 11.7%, with materials purchased down by 13.1%
and fuel costs down by 0.7% when compared with April 2014. The 0.1%
drop in the consumer price index (CPI) in the twelve months to April certainly
attracted the headline writers. But it partly resulted from distortions to travel
costs associated with the timing of Easter. The retail price index (RPI)
increased by 0.9% in the year to April, as did the former RPIX target measure,
while the ‘double-core’ RPI defined to exclude house prices as well as
mortgage rates went up by 0.4%, as did the tax and price index (TPI). The
latter is noticeably below the 1.9% increase in average earnings in the year
to 2015 Q1 (private sector 2.4%, public sector 0.2%) and suggests that the
living standards of those in employment are now unambiguously rising.

More generally, a period of falling prices has both income and substitution
effects. It is the balance between these offsetting forces that determines
whether the impact of a reduced price level is expansionary or contractionary
overall. The income effect is clear cut; lower prices increase real disposable
incomes for all those whose incomes from work or savings are fixed in nominal
terms. It also eliminates the fiscal drag that would otherwise bring more
people into the tax net. The substitution effect arising from negative inflation
is that the price of future goods and services becomes cheaper compared
to buying the same items today, theoretically leading to a reduction in current
expenditure. A falling price level also has three offsetting monetary
consequences. First, it increases the real value of money and other liquid
assets, leading to an increase in expenditure. However, the second and third
effects are that negative inflation: a) increases the real value of existing debt
burdens, and b) can lead to higher real interest rates once nominal rates hit
the zero bound. The latter can, in turn, lead to an appreciation in the external
value of a currency if the relative real interest differential in favour of the
currency is raised. Deflation alarmists tend to emphasise the substitution
and debt burden effects of a falling price level. However, these probably only
predominate when the price level is falling sharply, as in the US – but certainly
not Britain – during the 1930s. With the M4ex broad money definition having
grown by 4.1% in the year to March, which is very broadly where it has been
for a couple of years, there seems to be little reason to worry that the growth
in the supply of broad money is inadequate to fund a continued expansion
of home demand. However, the deflation-induced rise in the real interest rate
return from holding money on deposit needs watching because it could lead
to an increase in the demand for money that counterbalances the growing
money supply. Going against this concern is Britain’s continued large deficit
on its external trade in goods and services, which worsened from £5.97bn
in the final quarter of last year to £7.48bn in the first quarter of this year. This
imbalance suggests that there is already a substantial excess of home
demand over domestically produced supply.

Presumably, Mr Osborne’s forthcoming 8th July ‘mini-Budget’ will have more
to say on the economy’s supply side and hopefully back this up with serious
proposals for tax simplification, regulatory reform and increased fiscal
parsimony. As far as the 4th June Bank Rate decision specifically is concerned,
there is probably a stronger case for a pre-emptive hike than is generally
recognised, given the apparent excess of home demand over UK supply
revealed by the trade figures and the scope for a post-election rebound in
investment and jobs. However, the rise in real interest rates caused by the
elimination of inflation and the strength of sterling suggest that there has
already been some accidental monetary tightening through the back door.
Furthermore, when a rate increase is delivered after such a long period of
stasis it is important to reduce any adverse psychological shock. Holding
Bank Rate in June, and perhaps on 9th July, seems appropriate. However,
the Bank of England should be making a start on preparing the ground for
a couple of modest ¼% rate hikes, possibly as early as the 6th August
decision when a new set of Inflation Report forecasts will be available. There
is little need for British rate setters to wait for the US Federal Reserve to
make the first upwards move, which may be the current philosophy.

Vote by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by 0.25%
Bias: To raise rates to 1½% over 12 months

The decisive UK election result brings a welcome, if unexpected, clarity to
both fiscal and monetary policy. The ‘stability budget’ statement by the
chancellor on 8 July will attempt to bring the public finances back on track
during the life of the parliament. However, the MPC is in no less need of a
policy reset, despite its supposed independence from the political cycle. If
normalisation in the fiscal dimension looks something like a cyclically-adjusted
budget balance, then normalisation in the monetary dimension looks like a
real interest rate that approximates to the underlying pace of real economic
growth and broad money supply growth of at least the pace of nominal GDP.
The MPC has urgent work to do on both fronts: lifting policy rates towards
1.5% as soon as is practicable, and relaxing the regulatory stranglehold on
the banks that prevents a recovery in loan growth.

Today’s mildly negative CPI inflation rate should fool no-one. It is true that the
UK is no longer at the head of the table of EU harmonised consumer price
inflation rates. Yet it is remarkable that the UK, despite enjoying a 15% currency
swing versus the Euro over the past year, still has the sixth-equal highest
inflation rate. UK remains an inherently inflationary economy.

The forces holding back inflation are many and various. Bank lending to the
domestic private sector has been heavily constrained by the requirements on
the banks to rebuild capital and liquidity in the wake of the global financial
crisis. Consumer credit growth has revived over the past year but mortgage
lending remains extremely weak. Credit conditions continue to thaw as very
low interest rates gradually percolate through the financial system to households
and smaller businesses.

The supermarket price-war that has raged for many months is a temporary
bloodbath from which a new pecking order and new-found profit opportunities
will emerge.

Economic migrants have played a significant role in restraining unit wage
costs in a wide variety of occupations and industries. The UK has porous
borders and has only recently taken steps to limit migrant access to welfare
benefits.

The irrepressible and irresponsible expansion of global manufacturing capacity,
mostly in Asia, has also played a prominent role in suppressing goods inflation
in the UK over the past 30 years. As economic realities (the market cost of
energy, materials, labour and capital services) have closed in on the proponents
of mercantilism, the disinflationary benefits of cheap goods have diminished.
The fracking of the international crude oil cartel has been extremely influential
in the European inflation debate in recent months and the world watches and
waits to see whether OPEC can restore a semblance of price discipline after
its June meeting. The UK is a mere observer in this regard.

Finally, the extent to which international inflationary forces are experienced
in the UK is filtered by the external value of Sterling. The UK’s strategic decision
to remain outside the Euro area has resulted in some massive inflows of
financial capital during the past four years, not least into government securities.
On a trade-weighted basis, Sterling has sustained its appreciation, particularly
against the Euro and the Yen. Should the Euro area recover its economic
vigour, there is a presumption that capital will readily repatriate.

The relative strength of the inflationary pressures on the UK economy is soon
to be reasserted over the disinflationary ones. The most important judgement
concerns the rate of unit labour cost inflation. We reiterate the view that a
dramatic tightening of UK labour market conditions is about to unleash a
surprisingly powerful acceleration in employment costs. We expect whole
economy unit labour cost inflation to recover to 2.5% per annum in 2016 and
3% in 2017.

Does this scenario constitute an inflationary challenge to the Bank of England?
Does it presume a tightening of monetary policy? As far as 2015 is concerned,
the answer to both questions is most probably in the negative. What would
give members of the MPC pause for thought is an economic downturn that
coincided with wage acceleration. The non-appearance of a recovery in labour
productivity raises the stakes for the inflationary outlook and this should colour
monetary policy decisions today.

The last piece of the inflationary jigsaw is the revival of broad money growth,
whether triggered by an upsurge in private domestic bank lending (businesses
and individuals), lending to the government or the result of movements in the
external finance position. The accommodation of inflationary pressures by
the banks remains a key component of the inflationary scenario.

As the UK economy regains momentum after its pre-election lull and as house
prices surge forward anew, now is the time to bite the bullet and raise Bank
Rate, initially by 0.25%, at the June meeting.

Vote by Mike Wickens
(University of York and Cardiff Business School)
Vote: Raise Bank Rate by 0.25% and decrease QE to £250bn
Bias: To unwind QE and slowly raise rates as the economy grows

Based on fundamentals, bank rate and interest rates should have been higher
for the last year or two. The difficulty facing the MPC is that, because the
fundamentals have not change significantly, there has been no ready justification
available to the MPC to explain to the public why an interest rate rise is
appropriate. Until there is a major change in fundamentals the MPC is trapped
into too low rates. The most likely change in the short term that would allow
the MPC to raise rates is a rise in US rates.

A measure of the extent of the distortion in the MPC’s monetary policy stance
is the search for yield in the stock market that has seen stock prices rise
steadily. The ECB’s recent QE has had exactly the same consequence.
Moreover, even though sovereign risks in the eurozone have not reduced,
sovereign borrowing rates have fallen steadily – again reflecting the distortionary
effects of monetary policy.

Wage rises often provide the fundamental that leads to higher interest rates.
In the UK wage rates are on the rise. This is a reflection of rising demand
despite low labour productivity and a large increase in the supply of unskilled
labour in large part through immigration.

The low productivity has been regarded as a huge puzzle. It shouldn’t be. In
effect in the UK we have seen labour capital substitution: low business
investment leading to low capital accumulation (a low numerator in the
productivity ratio) and high immigration leading to an increase in employment
(a high denominator). Although the UK has experienced reasonable growth,
much of this is in services which has low capital-labour ratios and uses mainly
unskilled labour. Wage fundamentals are therefore unlikely to provide the
excuse the MPC needs.

Vote by Trevor Williams
(Lloyds Bank & Derby University)
Vote: Hold
Bias: neutral

No change to rationale from last month.

Policy response

1. On a vote of six to three the committee agreed to hold the Bank Rate at
its current level.
2. Two members voted for a rise of 0.25%, and one for a rise of any description.

Date of next meeting
Tuesday, 14th July 2015

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent
economists drawn from academia, the City and elsewhere, which meets
physically for two hours once a quarter at the Institute for Economic Affairs
(IEA) in Westminster, to discuss the state of the international and British
economies, monitor the Bank of England’s interest rate decisions, and to
make rate recommendations of its own. The inaugural meeting of the SMPC
was held in July 1997, and the Committee has met regularly since then. The
present note summarises the results of the latest monthly poll, conducted
by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School,
Cardiff University, and its Chairman is Trevor Williams, visiting professor,
Lloyds Bank. Other members of the Committee include: Roger Bootle (Deloitte
and Capital Economics Ltd), Tim Congdon (International Monetary Research
Ltd.), Jamie Dannhauser (Ruffer), Anthony J Evans (ESCP Europe), John
Greenwood (Invesco Asset Management), Andrew Lilico (Europe Economics
and IEA), Patrick Minford (Cardiff Business School, Cardiff University), Gordon
Pepper (Cass Business School), David B Smith (Beacon Economic
Forecasting), Akos Valentinyi (Cardiff Business School, Cardiff University),
Peter Warburton (Economic Perspectives Ltd) and Mike Wickens (University
of York and Cardiff Business School). Philip Booth (Cass Business School
and IEA) is technically a non-voting IEA observer but is awarded a vote on
occasion to ensure that exactly nine votes are always cast.